Lowdown on Income-Based Repayment Plans

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Published February 20, 2013

| Bankrate.com

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For students drowning in debt, there is one saving grace -- wait long enough and the government might pay off your loans for you. An option that's only available for federal student loans, the government's income-based repayment programs cap borrowers' monthly loan payments according to their income and forgive all debt after years of consecutive payments. Having the government pay off your loans sounds like a dream come true, but borrowers in these programs can easily wind up paying more than they would with a different payment plan, experts say. Here's what you need to know.

There Are Several Options

There are four income-based repayment programs, but they operate along the same basic guidelines.

The income-based repayment, or IBR, program, allows borrowers to cap their monthly loan payments at 15% of their discretionary income, which the Department of Education reports as 150% of the current poverty line. That means for 2013, income-based repayment enrollees without dependents will only have to pay 15% of earnings more than $16,755. Borrowers can qualify for loan forgiveness after they've made consecutive payments for 25 years.

Calculate Your Income-Contingent Plan Payment

Under both plans, borrowers who move into public service professions such as nursing or public defense can qualify for loan forgiveness after 10 years of consecutive on-time payments.

In December 2012, the government rolled out another income-driven plan that lowers payments even more. The Pay As You Earn program caps payments at 10% of discretionary income and offers loan forgiveness after 20 years. The catch is that it only applies to borrowers who took out their first loan on or after Oct. 1, 2007, and received a loan disbursement on or after Oct. 1, 2011.

Is Pay As You Earn Right for You?

To figure out what your loan repayment will be under the Pay As You Earn program, use the government's Pay As You Earn Calculator.

An income-sensitive repayment program is also available for certain low-income borrowers with payment caps as low as 4% of gross monthly income. However, forgiveness isn't available with this program.

Repayment Plans Can Cost More

"The thing with all these income-driven options is you have the flexibility to pay even less than the interest that is accruing every month and that is a mixed bag," says Heather Jarvis, an attorney specializing in student loan education and founder of AskHeatherJarvis.com. "It can be good if you need a reduced monthly payment because you don't have sufficient income, (but) it can be expensive over time because the longer it takes you to repay your debt, the more you pay."

And interest accrues fast. A graduate with $30,000 in loans at a 6.8% interest rate will add more than $2,000 to the cost of his loan if he doesn't pay interest for a year.

"Few borrowers who enroll in (income-based repayment) understand the full consequences of negative amortization," says Alex Holt, program associate with the Education Policy Program for New America Foundation, a nonprofit public policy institute in Washington, D.C.

There are some safety measures built in for borrowers. The income-based repayment plan, for example, prevents interest from capitalizing as long as your monthly payments under the plan are lower than they would be in a standard 10-year repayment plan. The income-contingent plan stops loan interest from capitalizing after the loan principal is 10% higher than the original loan balance. However, neither prevents interest from accruing.

Forgiveness Isn't Certain

How big the loan grows frequently doesn't make a difference to those banking on loan forgiveness.

"Unfortunately that's probably not going to happen for very many borrowers," says Melet Leafgreen, assistant director of loan programs for Texas Christian University in Fort Worth, Texas. "If they're in repayment ... most people after that number of years will not have a loan balance left to forgive."

A study by the New America Foundation shows that the only borrowers who truly benefit from the loan forgiveness provision are low-income borrowers whose income stays low; borrowers who have very high student loan debt; and those who qualify for public service loan forgiveness, which kicks in after 10 years of payments.

"It's very possible for someone with $30,000 to $40,000 in loans to get loan forgiveness under Pay As You Earn, even if they end up earning a high income later on," says Holt. "The higher the debt, the more likely you are to get loan forgiveness."

Forgiveness also comes with strings attached. Even if the government forgives all or part of your loan, you'll still have to pay taxes on the amount forgiven unless you qualify for public service loan forgiveness.

Even with the drawbacks, Leafgreen says that the income-driven repayment programs are smart moves for any borrower facing financial hardship.

"It's something that will help a lot of students stay out of default and stay in good standings on their loans," she says. "It's not the best way to get a lower balance."